Owner’s Choices: Short Sale versus Deed In Lieu of Foreclosure

A deed in lieu of foreclosure occurs when an owner gives a deed to the property to the lender in order to avoid the foreclosure process. It is commonly called a deed in lieu. The benefit to the lender is it saves the time and expense of the foreclosure. The lender will only accept a deed in lieu if there are no other liens on the property i.e. not other loans, judgments or secured debts. The reason for this is that the lender does not want to take over the obligation to pay the other debts that are secured by the property. If the lender has a first lien and forecloses, that foreclosure eliminates the other junior liens, other than IRS liens. So the deed in lieu has to be the same result of clean title as a foreclosure in order for the lender to be interested.

The advantage of a deed in lieu is that it only takes one negotiation. If the bank accepts, the owner is done with the house. One of the essential goals of the negotiating with the bank is to get a complete release from the debt. In other words, the owner wants the bank to accept the property in full satisfaction of the entire debt, so that the owner will not be chased by any debt collectors after the recording of the deed.

The byproduct of this result is a benefit for tax consequences. If the property is taken in full satisfaction of the debt, there is no debt relief i.e. the debt was fully paid. Without debt relief, there is no income tax consequences of the deed in lieu, unless the IRS wants to challenge the transaction by claiming that the market value of the house was less than the full value of the debt. So, the owner needs something like a market analysis to have on file showing that the amount of the debt was equal to the market value of the property.

The owner can also negotiate as smooth transition out of the house, with a reasonable time to move to a new location.

One disadvantage of a deed in lieu of foreclosure is the effect on your credit score. Under the Fannie Mae guidelines, a deed in lieu will make you ineligible for that type of loan for four years. In contrast, a short sale takes two years to “season.” Also, the standard loan appllication not only asks about foreclosures in the last 7 years, it also asks about a deed in lieu of foreclosure for that same period of time. For a deed in lieu, you have to answer the question “yes” for 7 years. For a short sale, the answer is “no.”

A lender does not have to accept a deed in lieu. There have been owners who have written out a deed, recorded it and sent it to the lender. They do not have to accept it. So, a deed in lieu is not a sure thing. Neither is a short sale, a bank does not have to do a short sale either.

The deed in lieu is a sale for purposes of income tax, just like a foreclosure and a short sale. So, if you made a profit you may owe tax on the gain. But section 121 of the Internal Revenue code eliminates the tax on a gain of up to $250,000 for a single tax filer and up to $500,000 for taxpayers filing jointly for a qualified principal residence.

Why aren’t there more deeds given in lieu of foreclosure? Many people do not know about them and some Realtors do not discuss that alternative as there is normally no commission paid. Since the short sale is a sale, the Realtor gets a commission. Since the deed in lieu is not like a normal sale, there is normally no commission.

You are doing the right thing. Let the owners know all the choices, and they will have the information to pick what is best for them. Even though a deed in lieu would not make you any money, providing that information shows that you have your client’s best interest at heart. Good for you. Tim Burrell